Wednesday, August 31, 2011

What Are the Markets Telling Us?

If it weren't for various copyright issues, I would be tempted to post in entirety Martin Wolf's column in this morning's Financial Times.

Mr. Wolf does a masterful job of laying out the current economic and market environment. Here's how his piece starts:

What has the market turmoil of August been telling us? The answer, I suggest, is three big things: first, the debt-encumbered economies of the high-income countries remain extremely fragile; second, investors have next to no confidence in the ability of policymakers to resolve the difficulties; and, third, in a time of high anxiety, investors prefer what are seen as the least risky assets, namely, the bonds of the most highly rated governments, regardless of their defects, together with gold.

Our problem, as Mr. Wolf goes on to explain, is that there is virtually no appetite for risk among investors or corporate managers, which can only have negative long term implications for economic growth and job creation.

The risk aversion in the markets has created some uncomfortably anomalies. For example, any asset class that might be considered "safe" offers little or no yield. Buying intermediate maturity corporate or municipal bonds may offer some psychic comfort, but with yields below 1% on most maturities under 5 years the investment appeal is limited.

Rates only have to tick modestly from current levels for "safe" intermediate bonds to record a loss for the year, yet investors are still flocking to the sector.

The stock market offers a more attractive alternative, but this month's extreme volatility illustrates the lack of conviction in the investment community. Ned Davis Research points out this morning that the median 63-day correlation between stock prices in the S&P 500 is at an all-time high - this is a market dominated by traders, not investors.

Put another way, it has been a difficult market for investors who want to base decisions on fundamental analysis. Stock picking has been largely a futile exercise - beta trades are the only way to go, at least in recent weeks.

So what's next?

I still lean towards dividend-paying larger cap stocks, but am mindful that we are up nearly +10% since the lows in early August. The risks of a major policy mistake seem to grow larger every day, not only in the United States but Europe as well.

Tuesday, August 30, 2011

Past Performance is No Guarantee of Future Results

Writing to shareholders in early 2000, Warren Buffett reported that the book value of Berkshire Hathaway had grown by just 0.5% in 1999 compared to a +21.0% gain for the S&P 500.

The reason was simple: in 1999, technology stocks dominated market returns. One of Buffett's investment disciplines is that he will not invest in companies that he does not readily understand, which is why he had largely avoided technology.

Buffett took full responsibility for the underperformance, which represented the worst relative performance since he began reporting to shareholders in 1965. Still, he kept his sense of humor:

Even Inspector Clouseau could find last year’s guilty party: your Chairman. My performance reminds me of the quarterback whose report card showed four Fs and a D but who nonetheless had an understanding coach. “Son,”he drawled, “I think you’re spending too much time on that one subject.”

Buffett could joke about the subject since he knew, as all investors do, that there will be periods of time when a particular investment style will fall out of favor with overall market sentiment.

However, over longer periods of time, a thoughtful and consistent approach to investing will nearly always yield satisfactory results, as Buffett's record obviously indicates.

This morning's Financial Times carried a long article discussing the poor relative performance of many prominent investors this year. It also notes that it is not unusual for managers to suffer through periods of time when their investment acumen seems to have deserted them (I have added the emphasis):

"The best managers have clear and consistent investment philosophies to which they adhere fairly strictly, even when this philosophy leads them to investments that are out of favor in the market," says David Shukis of Cambridge Associates, a US investment consultancy. Cambridge calculates that, of the investors it tracks who feature in the top quarter by performance over the past decade, about half have spent at least three years in the fourth quartile.

Please re-read the last sentence of the excerpt from the FT.

Cambridge is saying that some of the best investors it tracks - the ones ranked near the top for the last 10 years - spent at least 30% of the last decade in the bottom ranks of investment manager rankings.

This illustrates to me the fallacy of choosing managers strictly on the basis of past performance. And yet in nearly every manager search that I have been involved in, past performance plays a crucial role in the hiring and firing decision.

Even though the mutual fund industry constantly reminds us that "past performance is no guarantee of future results", investor still too often make their decisions looking squarely in the rear view mirror.

Friday, August 26, 2011

Steve Jobs' 2005 Stanford Commencement Address

After reading a number of articles about Steve Jobs and Apple, I remembered this terrific commencement speech he gave at Stanford a few years ago.

There are lots of lessons to be learned from his talk, and I encourage you to watch the entire video, but here's an excerpt that has stuck with me:

Your time is limited, so don't waste it living someone else's life. Don't be trapped by dogma - which is living with the results of other people's thinking. Don't let the noise of others' opinions drown out your own inner voice. And most important, have the courage to follow your heart and intuition. They somehow already know what you truly want to become. Everything else is secondary.

Thursday, August 25, 2011

Is the Market Expensive or Cheap?

While I remain constructive on the outlook for stocks - especially dividend-payers - I am aware that some of my valuation metrics might be challenged.

For example, I have pointed out that the price/earnings (p/e) multiple of the S&P 500 is attractive relative to historical averages.

In addition, the dividend yield on the S&P is nearly equal to the 10 year Treasury note, which is a situation that has not existed in the capital markets for nearly 50 years.

On both measures, then, I say that it is not a bad time to be buying.

The Lex Column in this morning's Financial Times takes issue with using either P/E ratios or dividend yields as a guide to stock purchase decisions.

In the spirit of keeping Random Glenings a democratic site, I thought I would mention their comments.

First, as to P/E ratios:

... In the U.S., for example, investors are hearing that the market is trading on a forward p/e of about 10 times, while the long term average is about 15. Forget that analysts always inflate future earnings. The big flaw with this approach is that current or near-future earnings are very unlikely to represent an equilibrium return from stocks.

Oh, so this means that we shouldn't be buying here?

Unfortunately, it's not that simple, says the Financial Times:

Valuation mirages can work the other way, too. As Smithers & Co notes, the trailing p/e for the U.S. market in 1933 was 50 percent above average, and the forward p/e looked high too. The following three decades, however, turned out to be fantastic for stocks. Indeed, looking at investment periods of up to 30 years, beginning in 1871, American companies actually ended up being expensive in hindsight a third of the time, in spite of looking cheap on a p/e basis beforehand.

As to dividends, the FT piece that it is not exactly fair to compare dividend yields to bonds, since dividends are paid at the discretion of management while coupon payments are legal obligations.

Whoever said this was easy?

Wednesday, August 24, 2011

Dividends or Stock Buy-Backs?

About a year ago, I had the chance to have lunch with Patricia Yarrington, CFO of Chevron.

I was one of several money managers at the meeting, and it was a great opportunity to hear about how one of the largest oil companies in the world operates.

One of the parts of the meeting that stuck with me occurred towards the end of lunch. After her remarks, Ms. Yarrington turned to the assembled group of investment professionals and asked a question.

"As you know," Ms. Yarrington said, "Chevron throws off a tremendous amount of cash flow each year - more than we need for our company's operations. We already pay a fairly generous dividend (more than 3%) but we could certainly increase our payout. Or we could begin to buy back more of our stock, which we believe is currently undervalued. Which option do you think we should pursue: higher dividend or stock buy-back?"

For me, the question was pretty simple: as someone who manages money largely for individuals and smaller institutions, a higher dividend yield is always welcome, which is what I indicated to Ms. Yarrington.

However, somewhat to my surprise, the majority of managers in the room thought that buying back stock was the preferred choice.

And, sure enough, a few weeks later Chevron announced a major buyback program.

I was reminded of this meeting recently when I was reading a number of research pieces which discussed the huge cash hoards that corporate America has amassed. With the S&P 500 now offering a 2.2% yield, and only a 26% average payout ratio, it seems to me that dividends should only begin to increase in the months ahead.

On the other hand, if my experience at the Chevron lunch is any indication, corporate managers will be swayed by the stock buy-back argument, so perhaps dividends will not increase as much as I expect.

But as it turns out, according to an article published by Reuters, if companies really wanted to do what was best for shareholders, they would increase dividends. Here's an excerpt from a piece titled "Resisting the Urge to Buy Back Shares" that appeared in today's International Herald Tribune (I have added the emphasis):

The number of U.S. companies announcing buybacks is at its highest level in nearly three years, according to TrimTabs Investment Research, though the volume of buybacks is shy of what was seen in the past two earnings seasons. Given the recent vulnerability of the market, a wave of buybacks suggests U.S. companies may be doing better than usual at buying low and selling high.

Terry Smith, the veteran analyst and investor, has observed that, since 1972, U.S. dividend-paying stocks have produced annual total returns — meaning appreciation, including any fueled by buybacks, plus dividends — of 8.3 percent a year. Stocks in companies that don’t pay dividends, but may still sometimes undertake buybacks, have returned a paltry 1.4 percent per year.

Tuesday, August 23, 2011

Time for a Transaction Tax?

By some estimates, as much as 70% of the recent volume on the New York Stock Exchange has been computer-driven trading.

These are orders being placed not based on any economic or company specific reason. Instead, they are largely based on complex mathematical algorithms developed by funds hoping to exploit tiny changes in stock prices for quick profits.

These formulas may focus on order flow (i.e. high frequency trading) or momentum (e.g. "buy 'em when they're going up" or "sell 'em when they're heading south"). While perfectly legal, computer-driven trading mocks those who try to figure out why stocks move in any direction on a given day.

Today's market swings makes it very difficult for investors who base their decisions on fundamental analysis. It also makes market movements much more volatile, since the computer-driven trading can place huge buy and sell orders in a fraction of a second.

Ned Davis Research put out a report at the end of last week noting that the dominance of computer-driven trading has lead to an extremely high level of stock price correlations - in fact, the highest since 1987.

According to Ned Davis, the median 63-day correlation of stock price movements in the S&P 500 reached 0.84 as of August 17, 2011, as compared to the average of 0.45 over the last 40 years. Put another way, successful investing in recent weeks has been entirely based on momentum investing, and almost nothing on fundamentals.

This morning's New York Times carried an interesting idea: a sales tax on Wall Street. Every trade would carry a tiny sales tax which would both raise revenue as well as discourage hyperactive trading that creates such volatility.

As author Nancy Folbre, a professor at University of Massachusetts explains:

Most of us pay state and local sales taxes on most things we buy, and most casino gambling is subject to state taxes ranging from up to 6.75 percent in Nevada to 55 percent on slot machines in Pennsylvania.

But speculative purchases of stocks, bonds and other financial instruments in the United States go untaxed but for a tiny fee (less than a half-cent) on stock trades that helps finance the Securities and Exchange Commission.

In Britain, by contrast, a 0.5 percent tax on stock transactions raises about $40 billion a year. President Nicolas Sarkozy of France and Chancellor Angela Merkel of Germany recently announced plans to introduce a similar tax in the 27 nations of the European Community.

It is variously called a “transactions tax,” a “financial transactions tax,” a “security transaction excise tax” or a Tobin tax (after the Nobel Prize-winning economist James Tobin, who famously argued for its application to foreign exchange purchases in the late 1970s).

Wall Street, of course, hates the idea of a transaction tax, but perhaps its an idea whose time has come.

Monday, August 22, 2011

So What Should Investors Do Now?

I was supposed to be on vacation last week, but thanks to modern technology (curse you, Steve Jobs and Apple!) I was well aware of the carnage in the market.

The last four weeks have been the worst for the S&P 500 since March 2009. The papers are full of recession talk, and it is hard to find anyone who has a good word for stock investing.

I listed a number of reasons a couple of weeks ago that I remain convinced that stocks should play an important role in most investors' portfolios, and I still believe it.

To start with, I would note that the same economists who are so confident in their opinions that we are headed for a "double-dip" recession are the same ones who just six months ago were convinced that interest rates were set to soar as inflationary pressures loomed.

My point is not to criticize the economics profession, but rather to point out how difficult forecasting truly is. In my opinion, investors can only make decisions on the facts at hand, weighing the potential risks and rewards of various asset classes. History tells us that markets often move before economic fundamentals suggest.

Investing in a Treasury Bill with a 0% yield, or a bond yielding less than 1% (which is where most high grade bonds are trading these days) , makes sense only if you believe that we are heading for a severe decline in corporate America, which doesn't seem likely at this point.

Remember - and it seems so long ago - that we just finished the earnings reports for the second quarter, and fully three-quarters of the companies in the S&P 500 beat earnings expectations.

Corporate America is flush with cash, and corporate balance sheets are generally in good shape. Thanks to the Fed, the capital markets are awash in liquidity, and virtually no credit-worthy borrower is unable to get the funds they need. We are a long way away from the credit crunch of 2008.

Corporate insiders have been gobbling up their own company's shares at the fastest rate since March 2009, indicating a fairly high level of confidence in the future.

At 12x earnings, the market is priced attractively relative to longer term historic averages. The dividend yield of the S&P 500 is 2.2%, which is higher than the 10 year US Treasury note. Moreover, the payout ratio of the companies in the S&P is just about 26%, which not only means that today's dividend rates are sustainable but also that there is room for dividend increases.

I could go on, but you get my point: I understand that the market's technicals are currently not good, and there is a reasonable chance that the broader averages could move lower in the near term. But for anyone investing with a reasonable time horizon, larger cap dividend-paying stocks seem to offer the best potential returns.

Where could I go wrong?

My biggest concern is more political than economic. A rash decision made by either Congress or the President in order to gain a political advantage could turn today's slowdown into a full-fledged recession. Hopefully, however, cooler heads will prevail.

Friday, August 12, 2011

Why Do Investors Complain When Stock Prices Move Lower?

Before I head out on vacation next week, I thought I would share some wisdom from The Oracle of Omaha.

About a decade ago, Warren Buffett wrote a piece for December 10, 2001, issue of Fortune Magazine on the stock market. While the article made a number of good points, here was a portion that has stuck with me (I have added the emphasis):

This is the one thing I can never understand. To refer to a personal taste of mine, I'm going to buy hamburgers the rest of my life. When hamburgers go down in price, we sing the "Hallelujah Chorus" in the Buffett household. When hamburgers go up, we weep. For most people, it's the same way with everything in life they will be buying--except stocks. When stocks go down and you can get more for your money, people don't like them anymore.

That sort of behavior is especially puzzling when engaged in by pension fund managers, who by all rights should have the longest time horizon of any investors. These managers are not going to need the money in their funds tomorrow, not next year, nor even next decade. So they have total freedom to sit back and relax. Since they are not operating with their own funds, moreover, raw greed should not distort their decisions. They should simply think about what makes the most sense. Yet they behave just like rank amateurs (getting paid, though, as if they had special expertise).

These past few days - one of the most volatile periods ever in the stock market - have witnessed a reemergence of short-term thinking among so-called professional money managers, in my opinion.

One example: Bank of New York Mellon just imposed a fee on large pension managers who wish to place more than $50 million on deposit in their institution. For 13 basis points, large managers get the privilege of placing their funds under management - funds that presumably are being invested with a long term time horizon, to match the needs of their beneficiaries - with a very large custody bank.

Put another way, these funds will not be earning any interest or dividend income - they are guaranteed to lose money.

Or how does a money manager justify parking funds in US Treasury notes yielding 0.20% (before fees)? As a friend pointed out this morning, in would take 50 years in order to turn $1 into $1.10 at short term Treasury rates - yet there seem to be large demand for short maturity paper.

I don't know which way the market will trade over the next few weeks, but as I have argued in several blog posts this week the overwhelming odds favor the common stock investor for the next few years.

Yes, there are serious problems in Europe, and we are being governed by a very dysfunctional group of individuals in Washington. But buying bonds at the lowest yields since the end of World War II, or paying a bank to hold cash, hardly seems the stuff of professional investors.

Thursday, August 11, 2011

Notes On The Market

I'm getting ready for several meetings in the next couple of days, so I thought I would post my latest thoughts on the markets and investment strategy.

First, a bullish anecdote:

In August 2000, I was on vacation on Nantucket when I received a call from the office.

A good client of mine - who also happened to be a pretty savvy Harvard Business School professor - needed to speak to me immediately. When I called him, he directed me to sell all of his stocks - immediately.

It turns out that he had read Robert Shiller's book Irrational Exuberance, which described how the market had become unhinged from the fundamentals, and was likely to have a serious correction at some point.

Professor Shiller was absolutely right, of course, and my client's move was very prescient. The S&P 500 was above 1500 those days, and now is trading around 1,150.

My client largely has been out of the market for the past 10 years, and has been investing in corporate bonds. During that (painful) time period, the S&P has produced a total return of +29%, while high-grade corporate bonds have returned +100%, or more than 3x the return of common stocks.

So when I received a call this morning from my client asking me to put together a list of common stocks that I would suggest buying, I paid attention.

His logic, by the way, is in line with my thoughts of the past few days: namely, while there is no denying that there is risk in owning common stocks, the potential returns from stocks going forward is vastly superior to most alternatives, and so returning just a portion of his assets back to stocks makes sense.

Back to getting ready for my meetings.

Here's why I think investors should be sticking with stocks:

1. The economic fundamentals are OK, even if recent data is pointing to a slowdown. For example, the Leading Economic Indicators (LEI) has risen almost without interruption since March 2009, according to Ned Davis Research, even though it has slowed in recent months. Other data points would include last week's employment report, which showed some modest improvement in job creation;

2. As I wrote on Monday, there have been 93 corrections of 10% or more since the beginning of 1928, according to Ned Davis. In 25 cases, those downturns turned into full-fledged bear markets, defined as a decline of 20% or more. Put another way, the historical odds suggest that 73% of the time corrections do not turn into long bear markets. With interest rates low, and corporate profits robust, it seems that a prolonged bear market is less likely;

3.Bloomberg indicated this morning that insiders (i.e. company executives) have been buying stocks at the highest rate since March 2009, when the S&P 500 hit a 12-year low. As former money manager Peter Lynch once observers, insiders can sell the stock of their companies for lots of reasons, but they only buy for one reason: to make money;

4. Three-quarters of the companies in the S&P 500 beat earnings expectations in the second quarter. True, guidance for future earnings was muted, but this too would be expected given the current market volatility;

5. The Fed just announced on Tuesday that short-term interest rates would remain at 0% for next two years. If you don't need to make any money, and are worried about the world, then banks are a good alternative. Otherwise you are going to have invest somewhere;

6. Bond yields are puny. Are you really going to invest your retirement assets at less than 1% for the next 5 years or so? Really?;

7. Unlike 2008, credit conditions are very accomodative. A recent survey of small business owners said that 93% reported no trouble in getting necessary credit. Coporate bond yields continue to hit record lows;

8. Corporate America is flush with cash - nearly $2 trillion worth. The Fed's move is try to make holding this cash "painful" so that managements will invest in new plants and create jobs. These funds can also be used for M&A activity;

9.JP Morgan indicates that the after-tax dividend yield on the S&P 500 is 12 basis points higher than US Treasurys. This is the first time this has happened since 1962. If you need income, stocks are the better alternative;

10. Valuation of stocks is attractive. The S&P 500 is trading at 12.3x trailing 12 month earnings, compared with its average since 1954 of 16.4x, according to Bloomberg.

So is the picture totally rosy?

Unfortunately, no. Here's what I'm watching to see if I need to change my bullish position:

1. The financial sector is a mess, lead by Bank of America (BAC). Banks still have huge legacy problem loans from the last decade that they have yet to deal with. BAC is off nearly -40% since the beginning of July, and their debt is trading at 4% in the money markets - scary stuff;

2. Demand is still tepid. To get a truly robust recovery, consumers and businesses need to start spending, but most are still too worried;

3. While the US is wounded, the euro is on a death-watch. It will take a concerted action, lead by Germany, to save the eurozone from imploding. If the euro goes, debt problems could soar, taking the financial sector down with it;

Wednesday, August 10, 2011

Inside the Fed

Excerpt from an exclusive (and fictional) interview that Random Glenings had yesterday afternoon with Fed Chairman Ben Bernanke.

Random Glenings: Well, Mr. Chairman, quite an announcement today - low rates for the next two years. Can you explain your reasoning?

Ben Bernanke: It's obvious that the economy is not recovering as we had hoped. There are lots of reasons for the current economic malaise, but one of the big reasons, I believe, is that people are too uncertain about the future. The budget talks here in Washington were a perfect example.

RG: How so?

BB: Congress and the President took the country right up to the edge of default a couple of weeks ago, and for what? Budget cuts of $900 billion spread out over 10 years? This will hardly make a dent in our deficit. People are desperate for leadership, and they're not getting it.

RG: So how does keeping interest rates low help?

BB: What we are trying to do is help revive investment activity and create jobs. Our economy is swimming in cash and liquidity. I read the other day that Corporate America has $1.9 trillion in cash on their balance sheets - why don't they invest it, or at least pay a dividend?

RG: And so by telling corporations that the returns on cash will be 0% for the next two years you're hoping to force them to invest.

BB: Exactly. We are trying to revive the "animal spirits" in the economy that Professor Shiller at Yale is always talking about. Our economy is suffering from a combination of too much debt and too much caution. If we can get investment going again, and get unemployment lower, we can address a lot of our fiscal problems.

RG: And help the stock market?

BB: Oh, I don't really care too much about the market. I personally believe that Wall Street is the most overpaid group of people on the planet. My focus is on the same types of people that I grew up with in South Carolina - hardworking people who just want to live a decent life, make an honest living, and save for their future.

RG: Last fall you wrote an editorial for the Washington Post in which you implied that you wanted stock prices to go higher, which of course they subsequently did. Any chance you'll be writing another piece?

BB: Well, probably not. Unfortunately the overall message of my article was lost because of the one sentence about the stock market. No, I think today's actions speak for themselves: the Fed wants to move cash off the sidelines, and get it to work.

RG: Thanks very much.

Tuesday, August 9, 2011

No, We're Not Heading for a Repeat of 2008

A week ago, right before the U.S. Treasury was able to replenish its coffers through a debt auction, several observers noted that technology icon Apple actually had more cash on hand ($75 billion) that the U.S. government ($74 billion).

Corporate America is awash in cash - nearly $1.9 trillion. True, some of it is offshore, and is not likely to be repatriated unless the government offers some sort of tax holiday, but still: that's a lot of liquidity.

As I noted on Random Glenings last week, corporate bond yields are now at their lowest level in decades. Corporations can easily access the credit markets, paying only a fraction more than our AA+ rated government.

This is the major difference between now and 2008, in my opinion: the credit spigots are wide open, and virtually no credit-worthy borrower is lacking for funds.

In fact, today we have the opposite problem: our banking system is so flush with Fed-infused cash that a large custody bank - Bank of New York Mellon - is now charging a fee to any large depositor.

There are other differences between now and 2008:
  • Interest rates are much lower today. The 10-year Treasury was yielding nearly 4% at the time that Lehman Brothers went under in September 2008, but now offers a meager 2.35%. Corporate bond yields were also much higher - remember when Pepsi offered a 10 year note yielding 8% at par in October 2008. Options to investing in stocks are much more limited;
  • The S&P 500 was trading at 17x trailing 12 month earnings in 2008 vs. 12x now;
  • While a few money center banks are still in difficult shape (Bank of America and Citigroup), most financial companies are in much better capital shape than they were in the fall of 2008. Ed Spehar at Merrill Lynch, for example, notes the huge cash positions of life insurers like Met ($2.4 billion, or 7% or market capitalization) and Prudential ($2.6 billion, or 11% of market capitalization);
  • While some would argue that the Fed's intervention options are limited in today's environment, investors are surely aware our government is very aware of the importance of the capital markets to our society, and will act accordingly.
Finally, remember that the S&P 500 hit a record high in October 2007. Investor confidence was much higher starting in 2008 after the markets had rallied +75% since 2002. Judging from the calls I have been receiving, and the news coverage, I don't think anyone is unaware of the risks of investing in stocks.

The Wall Street Journal had a piece this morning comparing current conditions with 2008. Here's an excerpt, with the full link below:

Starting from the most obvious: The two crises had completely different origins.

The older one spread from the bottom up. It began among over-optimistic home buyers, rose through the Wall Street securitization machine, with more than a little help from credit-rating firms, and ended up infecting the global economy. It was the financial sector's breakdown that caused the recession.

The current predicament, by contrast, is a top-down affair. Governments around the world, unable to stimulate their economies and get their houses in order, have gradually lost the trust of the business and financial communities.

That, in turn, has caused a sharp reduction in private sector spending and investing, causing a vicious circle that leads to high unemployment and sluggish growth. Markets and banks, in this case, are victims, not perpetrators.

Monday, August 8, 2011

Seven Reasons Not to Panic

Weak economic data. S&P downgrades US debt. Eurozone in crisis. Gold soars above $1,700.

Stock markets tumble around the world, and the S&P 500 has lost more than 11% since the end of April.

Suddenly the world doesn't look very friendly for investors, but what should be done?

I've been getting lots of calls and emails, as you might imagine. Here's what I have been saying:

1. The S&P downgrade has symbolic significance but little else. Interest rates will move based on investor perceptions of value, not on ratings. Even this morning, after the downgrade news, yields on bonds have moved sharply lower.

Japan has been downgraded by S&P a couple of times over the last decade, and they are still able to borrow at rates around 1%. Canada was downgraded in the mid-1990's, and not only did interest rates move lower but their stock market soared as well;

2. In fact, a short piece written by Dimensional Fund Advisors (referenced by Ron Lieber of the New York Times on Saturday) notes that some of the best stock market returns were found in markets that were consistently rated below-investment grade*;

3. We just completed an earnings season in which roughly three-quarters of the companies listed in the S&P 500 exceeded expectations.

To be sure, guidance was cautious by most managements, but "setting the bar low" has been common over the last few years;

4. Several economic indicators are actually showing signs of improvement.

Last Friday's employment report was better than most expected. Money supply growth has been exploding in recent weeks, which often can lead to strong market gains. The gauge of leading indicators released by the Conference Board continues to point towards continued growth. These data points get less media attention but are useful nonetheless;

5. Valuation of stocks is attractive on both an absolute as well as relative basis.

For example, the S&P 500 now trades a 10x forward price/earnings, well below the 15.2x average of the last 10 years. The dividend yield of the Dow Jones Industrials is higher than the 10-year Treasury note. And the earnings yields (the inverse of the P/E ratio) is 4x the yield of the Treasury market;

6. Other than gold, commodities in general have been falling. Oil, for example, is down -14% since the end of April. Falling commodity prices should help the economy;

7. Falling stock prices do not necessarily indicate the beginning of a new bear market. John Dorfman, chairman of Thunderstorm Capital LLC, a money management firm in Boston, notes that:

There have been 93 corrections of 10 percent or more since the beginning of 1928, according to Ned Davis Research, Inc. In 25 cases, those downturns developed into full-fledged bear markets, as defined as a decline of 20 percent or more. So the historical odds suggest that the chance of the present correction turning into a bear market are 27 percent. It would be unusual for a bear market to start when corporate earnings are healthy and interest rates are low - but not impossible.

*"Sovereign Debt and the Equity Investor"

Finally, at times like this, it is worth remembering Warren Buffett's axiom to "Be greedy when others are fearful, and fearful when others are greedy".

When you see so-called smart money investors stashing funds in Treasury Bills yielding 0%, or even paying custodian banks like Bank of New York Mellon a fee to place deposits, you have to believe that a lot of bad news is already priced into the markets.

In my opinion, for the longer term investor, stocks represent the best combination of yield and potential capital appreciation.

I see little or no value in shorter maturity bonds yielding less than 1%.

While I admittedly missed the upward move in gold this year, I still don't understand the investment case for an asset that has little practical value and is worthless as a medium of exchange (i.e. try taking your gold coins to the supermarket).

It's going to be a bumpy ride, but with the S&P off less than -5% year-to-date I think this is a time for patience, not panic.

Thursday, August 4, 2011

Bonds Offer Little Comfort

With many investors concerned about events in Washington and Europe, I have a number of discussions concerning whether it makes sense to reduce equity exposures in favor of bonds.

In some cases it might: if there is a need for cash in the next few months, or if the market's volatility is just too unsettling to deal with, selling down to the "sleeping point" (i.e. the level where you can sleep comfortably at night) might make sense.

However, in my opinion, the investment case for bonds is less appealing. Interest rates on U.S. Treasurys have moved to very low levels.

In fact, in this morning's trading, the yield on 1-month Treasury bills is now negative (meaning you'll get back less than you invest).

What about corporate bonds?

Here again, yields are at historically low levels. As yesterday's Bloomberg notes, corporate bond yields are now the lowest on record:

Investment-grade corporate bond yields fell to 3.51 percent yesterday, surpassing the previous all-time low of 3.53 percent set Nov. 4, Bank of America Merrill Lynch index data show.

Finally, our bond area points out that municipal bond yields levels on maturities less than 5 years are now equal to the all-time lows reached in August 2010.

I could go on, but you get the point: The price for safety in today's market is extremely high.

Wednesday, August 3, 2011

What Should You Do Now?

The markets passed their verdict on Washington's work yesterday, and it was not pretty.

The S&P 500 declined by -2.5%. Since last week, when the noise over the federal debt ceiling reached a crescendo, the S&P has declined by nearly -6%, wiping out all of the market's gains year-to-date.

U.S. Treasury obligations, meanwhile, remain the investment vehicle of choice, as investors rush for safety. Treasury 10-year notes now yield 2.55%, matching the levels of last fall. More ominously, you have to go out at least 4 years in maturity to earn over 1% in the government debt market.

And there's more talk of recession.

So what should investors do now?

That's always a complex question, but let me offer a few thoughts.

First, recognize that the deal reached in Washington essentially accomplished nothing.

The $913 billion spending reduction that is being widely quoted is actually going to spread out over 10 years. In addition, roughly half of the cuts are scheduled to come from the defense budget, which I doubt will really happen.

Incredibly, tax rates are unchanged for all income classes. On a percentage basis, our federal tax burden remains at one of the lowest levels over the past few decades despite a budget deficit of $1.3 trillion for this year.

Put another way: there will come a time when federal fiscal policy will turn definitely restrictive, but not now.

Meanwhile, back in corporate America, things are actually not all that bad. Nearly three-quarters of the companies in the S&P 500 beat earnings expectations in the second quarter.

True, most company guidance was cautious, but this merely sets the expectations bar fairly low, which is what managements love to do.

Most analysts and companies I have heard recently indicate that business conditions are sluggish, but not anywhere close to the depths of the recession of 2008-09. Activity could slow significantly, of course, but for now we seem OK.

The S&P 500 is trading at 12x estimated 2012 earnings, and sports a 1.9% dividend yield. Dividend payout ratios are still very low, at 26%, meaning there is plenty of room for dividends to move higher even if business conditions are sluggish.

When you compare a dividend yield of 1.9% to the 5-year Treasury note yielding 1.2%, it seems to me that stocks are the better vehicle for most investors who can take a three to five year time horizon.

In short, my best advice for now: Take a deep breath. Washington is a mess, and we have serious problems ahead if we can't figure out a better way to govern. But hiding in a bunker at this point doesn't seem to make much sense.

And if you want to worry about something, take a look across the Atlantic Ocean at Europe. The eurozone is in full crisis mode, and the situation is not improving.

Or, to quote columnist Ambrose Evans-Pritchard from the London Telegraph:

"America is merely wounded, but Europe risks death."

Tuesday, August 2, 2011

Hey, It Could Be Worse

This morning's Lex Column in the Financial Times makes a cynical observation about the debt deal that was just reached in Washington:

The latest US budget accord is not the worst last-minute agreement in history. President Barack Obama may be weak, the leaders of the Congress foolishly stubborn and the agreement is not enough to calm markets for long, but Sunday's piece of paper (assuming it becomes law) has more going for it than, say, the 1938 Munich Agreement (which failed to prevent the second world war).

And that just about sums up the opinion of most writers about the deal, and mine as well.

Writing in the Washington Post's blog Wonkbook, here's columnist Ezra Klein's thoughts:

But with the details understood and the legislation on its way to a quick approval in the Senate, it's worth stepping back and saying what we all already know: This is a terrible, no-good, very bad deal.

It's not just that Congress waited until the last minute, taking an unnecessary risk in a fragile economy. And it's not just that the tough decisions got punted once again. This is a bad bill at a time when the economy -- and the American people -- needed a good one. It's a bill that does too little now, and too little later, and it comes in lieu of an obvious, achievable solution that would have done better.

In my opinion, the problem is that the deal does nothing to address the real problems facing our budget deficit. Whether you are Republican or Democrat, or whether you are against increasing taxes or not, the real issue here is how to pay the rising costs of our entitlement programs.

Again, the Lex Column in the Financial Times:

The federal deficit problem is largely a healthcare problem. Health programmes, primarily Medicare and Medicaid, will account for four-fifths of the increase in federal non-interest spending over the next 25 years, according to Congressional Budget Office.

And Sunday's agreement does nothing - zero - to address this issue. All of the savings are to come in the discretionary spending area, largely defense. Whether our enemies will let defense spending decline, of course, is not clear.

So should investors despair?

Well, maybe, but here's more optimistic view from columnist Ambrose Evans-Pritchard writing in yesterday's London Telegraph:

We have a glimmer of hope. The key indicators of the US money supply are at last firing on all cylinders, a dramatic turn for the better that would normally signal recovery or even a mini-boom within the next six to 12 months....

The broader M3 indicator (including large savings deposits) is growing at the optimal rate of around 5pc. It has been an uncannily accurate lead indicator at each twist and turn of our economic drama over the past five years, and is telling us now that the Fed’s kindling wood has at last begun to ignite the damp coals of the US financial system. There is no longer a 1930s liquidity trap. We can infer that the housing market may be nearing the end of its deep slump.

The economy is curing itself in time-honoured fashion...

Mr. Evans-Pritchard is much more concerned about Europe than the United States, and thinks that all attention will soon return to the rot that is threatening the euro zone.

Lots to think about today.

Monday, August 1, 2011

A Tale of Sound and Fury

Cartoon courtesy of

For now, at least, it appears that a deal has been reached, and the United States will be able to honor its obligations.

I don't know where you stand on recent events in Washington, but I am relieved that we seem to have reached a resolution. However, I must confess that when I read some of the details of the accord I thought: Was this what all the drama was about?

According to Wikipedia, the total size of the federal budget for fiscal 2011 (which ends on September 30) is expected to be $3.8 trillion, and a deficit of $1.3 trillion. The total size of the spending cuts is supposed to be about $913 billion - but spread over the next decade.

In other words, it took the collective wisdom of all of our elected officials in Washington to agree to cut, on average, $91 billion this year - or about 2% of the total budget.

And there's more: Writing in this morning's Washington Post, Ezra Klein notes that most of the expected cuts are due to come from the defense department - Social Security, Medicare and Medicaid are totally off the table, despite the undeniable truth that these three areas are the major causes of the federal budget deficits:

And that gets to the truth of this deal, and perhaps of Washington in this age: it’s all about lowest-common denominator lawmaking. There are no taxes. No entitlement cuts. No stimulus. No infrastructure. Less in actual, specific deficit reduction than there was in the Simpson-Bowles, Ryan, or Obama plans, and even than there was in the Biden/Cantor or Obama/Boehner talks. The two sides didn’t concede more in order to get more. They conceded almost nothing in order to get a trigger and a process, not to mention avoid a financial catastrophe.